Totally disagree with this reading. Larry David looked Elmo and his dad dead in the eyes and never acknowledged the puppeteers. The joke hinges on the idea that Elmo is real and Larry David would pummel a child on national television.
KAT:
"I just felt a calm and a peace that had to be come from the woman above (his mom). I felt like a kid. It was just fun out here. It felt like I was a kid getting ready to go play my Saturday AAU games and Sunday AAU games. In a way I felt like I was seeing her in the stands"